In: Finance
Imagine you are the treasurer of a Japanese company exporting electronic equipment to the United States. All revenues are received in USD and all other expenses (e.g., R&D costs, costs of employees etc) are incurred in Japanese Yen.
Required:
(i) Discuss whether you need to hedge the foreign exchange risk and factors you need to consider when designing contracts to hedge the risks.
(ii) If the company is able to raise the price of its product in USD if Yen appreciates without affecting the sales volume, how would you adjust your recommendation in part (i) and sell your strategy to other executives?
Hint: If the company is able to raise the price of its product in USD if Yen appreciates, what does it tell you about the company’s foreign exchange exposure? Which derivative security (securities) could be used to hedge this risk? There is no model answer to this question, you just have to provide reasoned explanations.
Answer 1) Hedge of the foreign exchange is the ultimate requirement of treasurer as strategy to reduce and manage the foreign exchange risk for USD and Yen. As company has income in USD but asked to made expenses in Yen , any change in exchange rate between two currency will directly impact cash flow or company. To manage these losses to company , company may use direct future or derivative contract on two currencies to hedge the position.
FRA (Forward rate agreement ) can be another method to hedge the ill impact of change in foreign exchange.
Answer 2) In case of appreciation in Yen , company will increase the price in USD to cover the additional cash requirement of operation . Such condition , not to impact the sales volume, will be hedge by use of FRA , as the change in foreign exchange will impact the interest rate in respective country .
Company may use FRA as tool to reduce the ill impact of change in exchange rate on company sales.